LeoGlossary: Venture Capital (VC)

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This is a source of funding. It is private equity meaning that it is not related to the money comes from funds set up for this purpose. They are not traded on the public markets.

The focus is typically on start ups although Venture Capital Firms will get involved in an established company and seek to restructure it. Individuals are typically well off investors who have the money to put forward.

It is clear that one of the components to Venture Capital funding is risk. These companies fund opportunities that banks will not touch. Start-ups are not eligible for bank financing since they tend to lack the financial stability and have the track record required.

In return for the increased risk, VC firms seek growth. Companies they invest in tend to have enormous potential for market impact. Of course, they also have a great chance of failure. The goal is to find those companies that can gain market share, grow users/customers, and expand in number of employees.

A typical arrangement is for the VC to provide different rounds of seed funding while the company is growing. Here is where customers/users are acquired. The firm is willing to forego any payout during this period since growth is the focus.

Naturally, the VC firm wants to get paid. There comes a point during the process whereby the focus shifts from growth to monetization. Ultimately, if the company goes public, the VC firm will receive a healthy payout.

Silicon Valley

Venture Capital is still a big part of Silicon Valley. Due to the size (and value) of many firms, the ability to fund through capital markets exists. However, VC firms are still the primary vehicle for incubators and start up companies.

The Small Business Investment Act of 1958 helped to greatly expand the appeal of the private equity. By offering tax incentives to companies for investing in small businesses, this set off an entire industry.

As technology expanded throughout the 1960s, the businesses who were developing the tech caught the attention of the venture capital firms. Areas such as electronic, medical, or data-processing were really booming and garnered a lot of money from the VC firms at the time. The expansion throughout the 1970s made Venture Capital synonymous with technology.

The private equity fund is still the primary structure utilized. A limited partnership was set up by private equity firms. This allows for the investment in the firm while the general partner being filled by the investment professionals. The investors are passive in this instance.

Similar to a hedge fund, there is a dual compensation format. A management fees is paid, typically 1%-2.5% annually. On top of this, the firm gets 20% of all profits.

Venture Capital became associated with Sand Hill Road. This is where many of the VC firms were physically located in Silicon Valley. Things moved to another level when the semiconductor industry started to ramp up. This is what made the 1970s transformative in this form of funding.

Some of the early Venture Capital firms were:

  • Draper and Johnson Investment Company
  • Sutter Hill Ventures
  • Asset Management Company
  • Kleiner Perkins
  • Sequoia Capital

The successes of early firms only attracted more companies. When Apple, Digital Electronic Corp, and Genetech made it big, the rewards to the funds were enormous. This attracted even the attention of Wall Street entities.

During the 1980s, as the stock market raged, the number of VC firms exploded. The crash in the market did take a number of them down. Many companies, such as General Electric and Paine Webber shuttered their VC arms. Other established entities shifted the focus away from start ups to more established companies.

This was a process repeated during the 1990s, with the run up to the Dot Com bubble bursting. The Internet craze saw many successes and drew in enormous VC capital. With the proliferation of companies that had IPOs during this time, it is easy to see how it cascaded out of control.

Some of those which were funded by VC money:

  • Netscape
  • Amazon
  • Yahoo
  • Lycos
  • Excite
  • E*Trade
  • Compuserv

When these companies went public, the return for the funds was enormous. Like the 1980s, when the stock market crashed, especially the NASDAQ, many venture capital firms were casualties.

The decline in valuations of the public firms meant a lot of the loss had to be written off. This resulted in the funds being underwater, a situation where the value of the assets was less than what was invested.

To compensate for this, firms looked to unload the assets, a move that paid them pennies on the dollar. The fire sale spread across the entire industry.

Funding

Venture Capital funding is much different than a traditional loan from either a bank or the capital markets. With VC funding, the money is being put up in exchange for a stake in the business. This is an illiquid investment meaning that exit is only done when the business is sold to another owner. It can be a single buyer such as another fund making the purchase or multiple ones which happens when the company is taken public.

Stages of Funding

  • Seed funding: The earliest round needed to prove a new idea, often provided by angel investors. This could also take the form of equity funding at this point.
  • Start-up: Early stage firms that need funding for expenses associated with marketing and product development.
  • Growth (Series A round): Early sales and manufacturing funds. This is typically where VCs come in. Subsequent investment rounds are called Series B, Series C and so on. This is where most companies will have the most growth.
  • Second round: Working capital for early stage companies that are selling product, but not yet turning a profit. This can also be called Series B round and so on.
  • Expansion: Also called mezzanine financing, this is expansion money for a newly profitable company.
  • Exit of venture capitalist: VCs exit when the company is sold. This can come through the secondary market, IPO, or an outright acquisition. It is simply a matter of newer investors entering to buy the shares held by the VC firms.
  • Bridge financing can come between the different rounds of VC funding. Here we see the amounts raised become smaller since they are meant to "bridge" the gap until the next series of funding takes place. It is meant to meet the ongoing expenses of the company.

As a company goes through its funding process, the valuation of the company is readjusted based upon each series. As more money is raised, the valuation affects the rest of the entity. Typically, as a company is growing, it will be able to raise more money for less of an equity position.

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